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Stephen M. Bainbridge and M. Todd Henderson

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Stephen M. Bainbridge and M. Todd Henderson

Limited liability is the most important feature of the modern corporation. In the introduction, we set the stage for our analysis of the scope limited liability by first offering an explanation for the doctrine. We start with the ideas of corporate separateness and corporate personhood—legal fictions that are based on state statutes deeming associations of various individuals called “corporations” to be treated as separate legal entities. We show that this simple fact enables corporations to engage in productive activity at massive scale that would not be possible in the absence of this legal trick. From here, we introduce the ideas of asset partitioning, of which limited liability is a flavor. Deeming a corporation to be a distinct entity permits individuals to isolate assets in the firm, thus shielding them from the creditors of the owners of the firm, as well as shielding the assets of the owners from the creditors of the firm. This isolation allows firms to borrow against and invest firm assets with more certainty and specialization, as well as allows risk-sharing at lower cost than otherwise possible. However, limited liability is not just a legislative diktat, it is, we argue, what the parties to any transaction would agree to behind the ex ante veil of ignorance. We consider four cases—contract creditors of public corporations, tort creditors of public corporations, contract creditors of close corporations, and tort creditors of close corporations—to show how the efficient default rule is one of limited liability. We then consider when exceptions are warranted from this default rule, grouping these all roughly under the umbrella of piercing the veil, or disregarding the legal separateness of the corporation in question. We admit our skepticism that the doctrine designed to optimize the exception to the rule of limited liability is effective at striking the right balance, and set out a plan of work to make that case.
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Stephen M. Bainbridge and M. Todd Henderson

In this Chapter, we provide a brief history of limited liability. We trace its origins back to Roman times, when the idea of corporate separateness was first used as we know it today. Although ancient in origin, the modern concept of limited liability did not appear until the early 19th Century. We thus show how limited liability is not inherent to the corporate form, but rather depends on the ends to which that form is applied. At times, whether in ancient Rome or modern America, that application demands the isolation of liabilities in the corporate entity, while at other times, the concept of shareholder liability for the corporation’s creditors is a more sensible one. We document how limited liability arose initially out of the concept of sovereign immunity – the state outsourced its functions, such as building a road, to a private entity, and gave this entity the immunity the state would have had had it done the work. But even early on there were contracts, such as the Roman peculium and the Middle Ages commenda, that permitted investors of capital in large and remote projects, such as sea voyages to achieve limited liability. Liability tends to follow control, then and now.We trace the scope of limited liability in continental Europe, the United Kingdom, and colonial America, but find that corporations were rare and limited liability still tied closely to the idea of state power. The big change came with an 1811 New York statute that liberalized incorporation and limited liability. This statute provided the model for other states and, several decades later, European countries, to expand the concept of limited liability to permit the specialization and fundraising necessary to fuel the industrial revolution. Finally, we describe limited liability today, which bears little resemblance to much of its history. We also discuss some relatively modern alternatives to limited liability, such as those used in California through the early part of the 20th Century, pointing out why they failed to provide a viable alternative to limited liability as we know it.
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Stephen M. Bainbridge and M. Todd Henderson

Limited liability has obvious social costs. Owners of small businesses may deliberately undercapitalize their corporations, while siphoning all profits out of the business, leaving persons injured by corporate acts without recompense. At the other ends of the scale—in an era of mass tort class actions—even the largest corporations may be unable to pay off their creditors in the event of major disaster. Yet, in either case, limited liability prevents the claimants from satisfying their claims out of the personal assets of the company’s shareholders. As a result, a substantial amount of the risk created by corporate activities is externalized onto those who interact with the corporation and society at large. Why? What countervailing benefits does limited liability provide to justify its place in corporate law? In this chapter, we consider five answers that have been offered by both courts and scholars: (1) limited liability is an inevitable consequence of corporate personhood; (2) in complex organizations, responsibility and, thus, liability are too difficult to assign; (3) limited liability serves as an inducement for business to take risks; (4) limited liability is an expression of nineteenth-century populist political theory; and (5) if they could bargain ex ante, shareholders and creditors would agree to a regime of limited liability, making it the so-called majoritarian default. All of these rationales have some validity, yet all also have deficiencies and gaps. On balance, however, we find them collectively persuasive that limited liability produces net benefits for society. While claims based on survival of an organizational form are always somewhat suspect, we also point to the corporation’s survival as evidence of limited liability’s fitness for purpose. In almost every country, limited liability entities dominate the economy.
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Stephen M. Bainbridge and M. Todd Henderson

Veil piercing is an equitable remedy that allows courts, in appropriate cases, to set aside the corporation’s shield of limited liability and allow creditors of the firm to satisfy their claims out of the shareholders’ personal assets. As famed US jurist and scholar Benjamin Cardozo noted, however, it is a doctrine “enveloped in the mists of metaphor”. Part of the problem is that there are multiple standards in use in the states. In this chapter we focus on the major variants: the alter ego standard, the identity (aka alter-ego plus) rule, and the instrumentality test. A second problem is that each is riddled with ambiguities and irrelevancies. As a result, judicial decisions often seem to be based on seat-of-the-pants justice, rather than the rule of law. Indeed, a prominent mid-twentieth Century corporate law scholar, Phillip Blumberg, aptly described veil piercing as decision-making by “metaphor or epithet” rather than reasoned analysis. Accordingly, in addition to providing a detailed description of each of the three tests, along with extensive references to both the case law and relevant academic commentary, this chapter extensively critiques the case law using both doctrinal and normative considerations. By doing so, we are able to identify the factors most relevant to veil piercing in specific cases, thereby providing a roadmap for lawyers and judges to argue and decide veil piercing issues. Particular attention is paid in this chapter to specific recurring issues that frequently involve substantial amounts of potential damages, such as piercing the veil of a subsidiary corporation to reach the assets of a parent corporation. This chapter also devotes attention to emerging issues, such as whether non-shareholders can be held liable on a veil piercing theory.
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Stephen M. Bainbridge and M. Todd Henderson

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Stephen M. Bainbridge and M. Todd Henderson

Veil piercing and enterprise liability claims arise not only for common-law tort and contract cases, but also from a variety of state and federal statutes. Although liability for the corporation’s owners is at stake in both cases, the issues are substantially different. Permitting corporations to be structured to avoid statutory obligations would easily undermine the goals of those statutes; this same problem is much less severe in cases involving tort and contract obligations. For instance, we show how following state corporate law rules about separateness would permit corporations to dramatically reduce their tax obligations, avoid various labor rules, and frustrate a variety of other legislative objectives. We describe the doctrine used by federal courts, noting how it varies widely across the circuit courts and across statutory schemes. Some courts try to look behind the tests, asking whether the business was structured to avoid the statutory obligation or for other purposes. But, as we show, this is question begging and, in any event, is likely to try to make binary what is likely a continuous function. The cases in this area of law provide a series of multi-factor tests, some of which are judge made, while others come from administrative agencies responsible for the statute in question. Unfortunately, we show how these tests provide no more certainty than veil piercing tests in state law claims. We also offer an alternative test for statutory claims. One could consider the importance of the public policy, how significantly it would be frustrated if corporate separateness were respected, and the costs of avoidance for firms. This can be thought of as a sort of Hand Formula for statutory veil piercing, where the benefits of limited liability are compared against the losses to public policy from respecting it.
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Stephen M. Bainbridge and M. Todd Henderson

This chapter elucidates two doctrines closely related to piercing the corporate veil. First, it assesses the highly controversial doctrine of reverse veil piercing. The corporate veil is most often thought of as a way of protecting shareholders by treating the corporation as a distinct entity, but sometimes it may be the shareholder rather than a creditor who wishes to disregard the corporation’s separate legal status. If successfully invoked, reverse veil piercing thus permits a shareholder to disregard the corporation’s separate identity, just as forward veil piercing permits a creditor to do so. Reverse veil piercing tends to be at issue in statutory cases, especially tax cases, where there are benefits from either giving the corporation the identity of the shareholders, or vice versa. After discussing the basic reverse veil piercing doctrine, this chapter turns to so-called outsider reverse piercing, in which a personal creditor of the shareholder seeks to disregard the corporation’s separate legal existence to reach assets of the corporation to satisfy its claim. Unlike regular veil piercing, in which a creditor of the corporation is trying to reach the personal assets of a shareholder, in this situation a creditor of the shareholder wants to reach the assets of the corporation: in order to satisfy the creditor’s claims against the shareholder. This chapter demonstrates that outsider reverse piercing is a particularly pernicious doctrine that should be sharply limited, if not outright abandoned.Finally, this chapter examines so-called enterprise liability. The mere fact that a corporation is part of a larger enterprise is insufficient to justify veil piercing. Splitting a single business up into many different corporate components thus will not result in the controlling shareholder being held personally liable for the obligations of one of the corporate entities. Under an enterprise liability theory, however, the creditor can reach the combined assets of all the firms making up the larger business enterprise.
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Stephen M. Bainbridge and M. Todd Henderson

Limited liability is not unique to corporations; since 1977, entrepreneurs could achieve limited liability through the use of limited liability companies (LLCs), as well. Not surprisingly, but, as we show, regretfully, where limited liability went, piercing followed. In this Chapter, we consider several flavors of LLC statutes, showing how the language varies on the question of whether investors in the LLC (known as members) would be liable for the debts of the LLC. But, we show how courts generally disregard the language, and pierce the LLC veil on grounds quite similar to those used to pierce the corporate veil. We look closely at cases in which plaintiffs try to disregard the LLC’s separate existence, styled both as veil piercing claims and as enterprise liability claims. Our survey of the relevant cases demonstrates that courts do no better in LLC cases than they do in corporate cases, and, in fact, do much worse in many cases. This is because courts sometimes pierce the LLC veil, even when it is not specifically authorized by statute or even seemingly forbidden by it. In addition, courts apply the same corporate formalities tests to LLCs that they use for corporations, notwithstanding the fact that one of the chief benefits of LLCs is that it enables businesses to operate with less formal governance provisions. Finally, we offer a normative view on LLC veil piercing. The rules encourage inefficient investment in irrelevant precautions, while encouraging expensive and complex litigation. They may discourage capital formation in small businesses by exposing those businesses to a disproportionate share of the burden from the tort liability system, which in turn under mines the valuable economic and democratic contribution of small business ownership and entrepreneurship. If veil piercing is to be retained in the LLC context, courts should to realize that piercing the veil threatens the very purpose of an LLC and thus is a subject to be approached with caution. In applying the conclusory and vague standards, courts should fairly convincing proof of all the factors that they are assessing before piercing the veil.
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Stephen M. Bainbridge and M. Todd Henderson

In this Chapter, we briefly look at the doctrine of veil piercing in several leading industrial nations. We observe limited liability everywhere in the developed world, from Canada to China. And, as we document, where limited liability goes, so too goes the doctrine of piercing the corporate veil. All the countries we survey permit courts to disregard the separate legal entity of corporations in a limited number of circumstances. Next, we briefly survey the types of limited-liability firms and doctrines for veil piercing in the United Kingdom, Canada, Australia, France, Germany, Japan, and China. We conclude that although the rules vary widely by name, doctrinal approach, and process, at the end of the day, most end up looking quite like their American equivalents. Courts rarely pierce, and when they do, it is mostly in an unprincipled way. Moreover, as in America, piercing is generally not done with an eye on creating the optimal incentives, but rather courts seem to be trying to achieve fairness or justice in ad hoc way in a particular case. The proxies for abuse of the corporate form that foreign courts use are similar to those used in the U.S.: disrespect for corporate formalities, unity of decision making, commingling of funds, and the like.